A Burger, Fries, and a Small Side of Contagion Please

Here's something that's probably not on your Christmas wish list, but should
be: a little bit of contagion.

Contagion is a word you don't hear often, unless you work at the CDC or on
Wall Street. Definitions of contagion, according to dictionary.com, include: "the
communication of disease by direct or indirect contact" and "the ready transmission
or spread as of an idea or emotion from person to person: a contagion of
fear."

Contagion in the investing world (be careful not to ask Santa for disease
contagion) is the fear that a run on one stock or asset class will spread into
other stocks and asset classes, resulting in a sudden and large drop in market
prices. High on the list of moral duties at the Fed and the Treasury is preventing
contagion.

Here's a general guide to how these things work. It's been going on for a
long, long time, so if you learn it now, it may help you your whole life:

Regulators ignore skeptics, afraid to step in front of an upwardly moving
market that is creating wealth for a lot of people. Regulators claim that "free
markets" are self-correcting and price assets appropriately (i.e. it is impossible
to forecast bubbles).

Eventually markets go so high that, like Icarus, they are brought down
by themselves.

The peddlers of the "financial innovations" run to regulators for a bailout,
citing unprecedented and unforeseen market conditions and the threat of contagion.

As long as the peddler is not too tainted (e.g. Ken Lay) and the threat
of contagion is credible enough, regulators move into action.

In watching Fed and Treasury, look for them to selectively use:

"free markets" as a justification for not regulating (when markets are
going up), and

"the interest of the greater good" as justification for regulating (when
overpriced asset come down and threaten contagion).

Greenspan was the master of this tactic1,
but Treasury Secretary Hank Paulson is a quick study. Paulson, who has repeatedly
argued against regulation of hedge funds and mortgage markets is now calling
for government intervention. According to the Wall Street Journal:

"The regulators didn't have clear enough visibility with what was going
on in terms of these off-balance-sheet SIVs," Mr. Paulson said to reporters...In
the short term, Treasury officials said the financial markets were in danger
of a large-scale dumping of assets by the banks, which would have hurt capital
markets and potentially spilled over to the broader economy [contagion!].
To avoid that, Treasury stepped in to facilitate discussions among the banks...Some
have criticized the Treasury for essentially helping big banks avoid the
financial pain associated with risky bets that didn't pan out. The reaction
in Washington, though, was more muted. Democrats sought to use the Treasury's
willingness to get involved to bolster their demands that the Bush administration
do more to help homeowners who are also suffering from the subprime downturn
[more government intervention by the Republicans means the Democrats should
get theirs, too].

So what's my beef with how this world works? Not much, in that knowing about
it, I am able to make a lot of money trading various stock and commodity positions
in a way that is favorable to me. However, despite the benefit it provides
me personally, I wish it didn't exist. I am concerned about the greater good
(wink, wink). My concern centers on inflation.

It's simple really. If bubbles go up (like housing) and then aren't allowed
to come down, the result will be inflation. Housing prices have gone up way
too far. By almost any metric, they are overpriced. First time buyers cannot
afford new homes. Mortgage payments as a percentage of income are elevated.
Owning a house vs. renting one is extremely expensive. Whatever way you look
at it, housing is overpriced.

If free markets are allowed to run their course, house prices will come back
down, possibly causing a short-term recession, but paving the way for long-term
economic growth. It will be painful, quick, and healthy.

But that's cruel, politicians will argue. People will suffer. Consequently,
politicians and regulators are trying to help. Bernanke wants to lower rates
to keep the subprime meltdown from spilling over into the broader economy,
Hank Paulson wants to save the big banks from suffering major losses, and the
Democrats want to help bail out subprime borrowers.

The road to hell is paved with good intentions. Each of these policies is
inflationary. If housing prices don't come down, everything else will have
to go up in value. How else will people be able to afford these houses relative
to their incomes? Either house prices must come down, or incomes must go up.
With banks running into liquidity problems, we're going to need a lot more
help (a.k.a. money) from the government, which means more money supply, more
credit, and a weaker dollar - all of which is going to lead to more inflation.

Markets, of course, are starting to get one step ahead of the regulators,
driving up the price of oil, food, gold, and more. Oil is already at $87 a
barrel and could easily go to $100 or more. Nonetheless, market watchers expect
the Fed to lower interest rates again on October 31st.

Until the regulators, led by Bernanke, change their tune and start taking
the threat of inflation seriously, it will continue to be advantageous to your
portfolio to own:

gold companies, like Nemont Mining (NEM), Tanzanian Royalty (TRE [a well-run
gold company doing a lot of prospecting in Tanzania]), and GoldHawk (CGHRF.PK [another
well-run mining company that started production Oct. 1 at a Peruvian gold
mine it acquired for a good price]

metals companies, like CVRD (RIO), and Liberty Minerals (LBEFF.PK [a Canadian
company opening new metals mines]).

If the smaller companies (TRE, CGHRF.PK, and LBEFF.PK) can get their new mines
up and running according to plan and without cost overruns, and metal prices
continue to move up, their stock prices could do extremely well. These companies
are good inflation hedges.

Don't worry about people claiming that oil and metal prices are already too
high. Unless Bernanke gets serious about inflation, prices should move higher.
Why? Because interest rates are a lot more accommodative than most analysts
are saying. Overall inflation (WITH food and energy) is higher than core inflation.
Yet, everyone is measuring by core inflation. I think it's incorrect to do
so.

Core inflation was developed to take out temporary spikes in food and energy.
But what if food and energy are on a long-term uptrend and core inflation is
on a long-term downtrend (driven by globalization)? If that is the case, one
misses the true trends by taking out food and energy. Greenspan recently said
that the theory of using core inflation is starting to lose some credibility
(he can tell the truth now that he's no longer in office).

But Bernanke is doing the opposite, arguing more than ever for the validity
of core inflation. Bernanke is under tremendous pressure to provide liquidity
(via lower interest rates) to the banks. To do so, he must argue that higher
oil and a falling dollar are not important. Only core inflation matters.

It seems as if hedge funds are the first to catch onto this inflation theme.
Eventually, they will be followed by PIMCO (but don't hold your breath), and
finally coming in last will be Bernanke.

A recent AP article gave clues about the direction he is leaning:

Bernanke once again pledged to "act as needed" to help financial markets
[in other words provide inflationary liquidity]...

"The further contraction in housing is likely to be a significant drag on
growth in the current quarter and through early next year," he said [I believe
he's using weak housing throughout 2008 to justify future rates reductions]...

On the inflation front, Bernanke noted that the prices of crude oil and
other commodities have been rising and that the value of the dollar has weakened.
Oil prices galloped to a record high of $86.13 a barrel on Monday...

Fielding questions after his speech, Bernanke said, "Part of the reason
that we have some confidence in inflation remaining well controlled is we
expect to see the economy growing more slowly at the end of this year" and
early next year [again the weak economy from housing is Bernanke's justification
for the Fed keeping liquidity flowing].

He said Fed policymakers were prepared to "reverse" the rate reduction if
inflation turned out stronger than expected [this statement is probably his
most important, but is it true?. If core inflation goes above 0.3%, will
he backtrack or follow through with this threat/promise and force the economy
into a recession? Watch the core inflation number! It's the most important
economic number right now].

To understand the pressure Bernanke is under, and why I believe he and other
regulators will continue to flood the market with liquidity (in spite of high
oil prices), look at the current state of the real estate markets.

One of my readers wrote saying he is a real estate agent, and that volume
is off 2/3 from normal. "And prices are soft," he wrote. "The lenders will
only provide an equity loan at 80% of value [if you have a credit score in]
the 750 fico range...if not forget it. When purchasing you need 725 [fico]
and 20% down...who has 20% in savings for a down payment? Not many...this is
a huge problem and the main reason homes are not selling. Not many can qualify
under the new standards!"

Another reader, also a real estate agent, wrote:

There are going to be a massive amount of foreclosures. About 47% of homes
on the market here are vacant.

Many of these same sellers did refinancing, pulling huge amounts of cash
out of these homes, leaving them with negative equity in the face of falling
prices. In effect, these homes were sold to the banks and eventually the
home debtors will walk away with their cash. Thanks to the new Mortgage Debt
Forgiveness Act, there will be little impact from this fraud [compare that
to Paulson calling for more government action!].2

However, the lenders will continue to tighten and those defaulting will
be out of the home market and credit market for seven years.

When I drive through a prospective neighborhood, I try to ascertain the
yearly median income. I multiply that times three to get a neighborhood sales
price range. Here in Phoenix, we need to come down 40 - 50% more [again,
either housing prices must come down or incomes must go up]. Since I have
lived in the same home for 30 years, I know this is pretty accurate for my
own neighborhood. Like you say, sellers are reluctant to drop price. We have
a long way to go.

Unless housing is allowed to run its course, the government will only cause
inflation, or more likely stagflation,. So although you probably didn't think
you wanted it, you might want to add a little contagion to your Christmas list.

In case you don't believe me, here are some final thoughts on stagflation
from Wikipedia (emphasis added):

Stagflation...a term...used to describe a period of out-of-control price
inflation combined with slow-to-no output growth, rising unemployment,
and eventually recession.
Stagflation is a problem because the...principal tools for directing the
economy...offer only trade offs between growth and inflation. A central bank
can either slow growth to reduce inflationary pressures, or it can allow
general increases in price to occur in order to stimulate growth. Stagflation
creates a dilemma in that
efforts to correct stagnation only worsen inflation, and vice versa. The
dilemma in monetary policy is instructive. The central bank can make one
of two choices, each with negative outcomes. First, the bank can choose
to stimulate the economy and create jobs by increasing the money
supply...but this risks boosting the pace of inflation. The other choice
is to pursue a tight monetary policy...to reduce inflation, at the risk of
higher unemployment and slower output growth.

In neo-classical economic theory, stagflation is rooted in the failure of
the overall market to allocate goods and services efficiently. The root
cause of this is generally thought to be excessive government regulation...

Stagflation in the U.S.A. was defeated by the then Federal Reserve chairman, Paul
Volcker, who sharply increased interest rates to reduce money supply
from 1979-1983 in what was called a "disinflationary scenario." Starting
in 1983, fiscal stimulus and money supply growth combined to create a sharp
economic recovery which is in line with standard macro-economic models; however,
there was a five-to-six-year jump in unemployment during the Volcker disinflation.
It appears that Volcker trusted unemployment to self-correct and return to
its natural
rate within a reasonable period, which it did.

Paul/Volcker in 2008!

[1] Greenspan
often uses a justification for not answering a question, then ignores the small
justification to answer a different question. This tactic was classic Greenspan
during Congressional testimony when he was head of the Fed, and he still uses
it today - just about every time he is interviewed. This week on CNBC, when
asked if oil prices were too high, he said that he couldn't second guess markets.
They priced things appropriately. Several questions later, when asked about
housing prices, he said they were going lower. I haven't yet seen an interviewer
who can get around it (except the great John Stewart).

[2] "Let
me be clear, despite strong economic fundamentals, the housing decline is still
unfolding and I view it as the most significant current risk to our economy," Paulson
said in a speech delivered at Georgetown University's law school. "The longer
housing prices remain stagnant or fall, the greater the penalty to our future
economic growth." Sounds great until you read what my reader wrote about the
fraud resulting from government action already taken.